With rails, it's all about the secular - by Tony Hatch

— by Tony Hatch

After watching as the broader market took rail stocks down in its ugly wake, and reading the less-than-constructive headlines, it is reassuring to consider the rails' actual second-quarter performance, their current traffic numbers, near-term expectations — and long-term opportunities.

The rails are cyclical and hardly immune to macro-events, as the 20 percent drop from peak-to-trough volumes in 2009 can attest. But they held their margins and vastly outperformed expectations during the Great Recession. Given what we heard during Q2 earnings discussions, I do not see an economic cataclysm in the offing. In fact, many (notably Union Pacific) see a strong, back-end-weighted second half with a late but sharp peak season.

Rails See Strong Second Half

In Q2, all six major rails beat the Street numbers; most modestly, some (see Norfolk Southern) did so by a lot. Analysts' numbers have been rising throughout the recovery, and comparisons are getting tougher; upside surprises are fewer and far between. But there was plenty to write home about in Q2:

• Rails averaged just over 16 percent year-over-year (YOY) earnings per share (EPS) growth, but if you throw out Canadian Pacific's 19 percent flood-impacted decline, rails grew EPS by 23 percent vs. the S&P 500's 18 percent estimated YOY growth. Volume growth slowed to 3.3 percent, more than double the estimated GDP (1.3 percent).
• Three rails reported operating ratios in the 60s — in descending order: NS, CSX and CN — as the flooding impacts receded and operating efficiency increased. Service had not yet improved through late July. It bears watching.
• The pricing story is secular and is a long-term positive for the group. Rail price increased about 5.2 percent YOY — perhaps 70 base points above the “new normal,” with eastern U.S. carriers leading the way and the Canadians bringing up the rear. 
• An economic slowdown? You couldn't tell by listening to the rails' second-half expectations or looking at traffic totals. Sure, traffic's been flattish, but cyclical volumes (from metals to forest products to chemicals to autos to intermodal) generally are up. It's the bulks (coal and grain) that are down — much of that (still) weather-related. If you look below the surface, there is nothing in the coincident indicator that is rail traffic to suggest that anything resembling a Great Recession repeat is in the offing.
• The spend/efficiency turnaround. Upfront costs, be it capex or in the income statement (hiring and training), were up. Being potentially slightly early on capacity spending is smarter — politically and in terms of future market share capture — than the alternative. Such “growth spend” can be shut down quickly, but I suspect the added capacity will be filled, and filled profitably, in the second half. The reversal of the upfront training expenditure, and the fuel surcharge lag turning to tailwind, will provide a productivity boost.

The Secular Case

And then there are the long-term opportunities. Here are five reasons why the rails' future is based on secular growth, not near-term cyclical events:

1. Intermodal is growing internationally (albeit slowly) and even more so domestically due to trucking productivity (driver turnover already has hit 75 percent), trucking capacity shortages, relative pricing, relative cost, fuel (and carbon) efficiency and cost comparisons, and relative infrastructures.

2. Coal is back. Domestic coal — which is looking less endangered over the intermediate term — and (especially) high-margin export look better than they did just a few short years ago.

3. Chemicals are back, too. Despite the regulatory battles between the rail and chemical industries, the real story is the plentiful availability of cheap feedstock (natural gas) — the reason for the so-far $4 billion in expansion capital set for the Gulf region. That's good for rails.

4. The shale business is the driver behind that secular change. It looks like a rail commodity with legs.

5. Always the subject of speculation and volatility, grain is a long-term secular growth story for rails. But not without a lot of noise — witness the upbeat U.S. Department of Agriculture corn plantings report and subsequent downward yield revision.

Bottom line: The rails have such a strong secular case that their intermediate to long-term futures are unthreatened by the recent market swings.

Tony Hatch is an independent transportation analyst and consultant, and a program consultant for Progressive Railroading's RailTrends® conference. Email him at abh18@mindspring.com.